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The Lowdown on Lean Accounting

A new way of looking at the numbers.

LEAN MANUFACTURING
PRINCIPLES FOCUS on eliminating
waste and producing only to meet customer
demand. They also typically require a
company to move from a functional division
of work to work cells where all of the
processes needed to manufacture a product
or line occur next to each other in
sequence.

AS COMPANIES IMPLEMENT A
LEAN APPROACH to
manufacturing, CPAs have begun to
realize many standard cost accounting
practices no longer make sense. A
growing number of businesses are
implementing lean accounting concepts to
better capture the performance of their
operations.

SINCE STANDARD COST
ACCOUNTING DOESN’T work in a
lean operation, adherents propose a new
way of looking at the numbers. Rather
than categorizing costs by department,
they organize them by value stream,
which includes everything done to create
value for a customer the company can
reasonably associate with a product or
product line.

WHILE USING ALTERNATIVE
ACCOUNTING CONCEPTS solves
some problems, it is not a panacea. CPAs
may have difficulty accurately pricing
products and determining profitability
when they analyze performance by value
stream rather than by individual
product. The approach also may emphasize
speed and quality almost to the
exclusion of cost concerns.

WHEN MOVING TO LEAN
ACCOUNTING, CPAs may want to
supplement the company’s standard
financial statements with additional
information that captures the resulting
improvements. Most CPAs will find the
cost information they need to prepare
lean financial statements already is
available in the company accounting
systems.

KAREN M. KROLL is a freelance
business writer in Minnetonka, Minnesota.

s with many companies that
implemented what are referred to as “lean”
processes in their manufacturing operations,
Landscape Structures Inc. has seen significant
benefits. Manufacturing lead times dropped 90%,
inventory turnover jumped 50% and production
capacity was freed up by about 25% each year.
According to CFO Fred Caslavka, CPA, the privately
held manufacturer of playground equipment in
Delano, Minnesota, has “had some big successes”
from applying lean manufacturing processes to its
business.

In contrast to traditional
mass-production operations, a lean company
emphasizes eliminating waste, boosting inventory
turnover and reducing inventory levels. The focus
is on achieving the shortest possible production
cycle and producing only to meet customer demand.
The benefits generally are lower costs, higher
product quality and shorter lead times.

As
a company implements this approach to doing
business, its financial statements often show a
temporary hit to the bottom line as deferred labor
and overhead move from the inventory account on
the balance sheet to the expense section of the
income statement, lowering profits. (See the glossary for definitions
of key terms.) This means a company’s financial
statements may not reflect the true financial
benefits of lean manufacturing. This dichotomy in
actual vs. reported performance presents a
challenge to CPAs seeking to accurately account
for a lean company’s finances. As a result, CPAs,
operations personnel and consultants have begun to
question the role of standard cost accounting.
This article explains the basics of lean
manufacturing and why CPAs may need to use
alternative accounting practices to help companies
better understand the benefits the process brings
to their operations.

Can’t Argue With “Lean” Results Gorton’s says it more than
met its original goal of lowering
inventories by 40% to 50%.

Xantrex Technology Inc.
says in one area it managed to reduce
lead times from eight weeks to one day
and improve productivity 100%.

Whirlpool Inc. says its
Oklahoma plant had a quality improvement
of more than 40% over the past two
years.

WHAT LEAN MEANS Although lean concepts can apply
to all aspects of a company’s business, to date
they’ve been implemented mostly on plant floors.
Adherents range from Pratt & Whitney, a
division of $31 billion United Technologies Corp.,
a maker of building systems and aerospace
products, to Lantech Inc., a $70 million
Louisville, Kentucky-based manufacturer of
packaging equipment.

Lean manufacturing
principles differ from mass production in several
key ways. For starters, the latter typically
concentrates on efficiency and machine
utilization, which can lead to long run times and
bloated inventory levels. “With lean, however,
it’s all about reducing waste,” says Alex Tawse,
CPA, CFO of the Kaizen Institute of America, a
global management consulting company, in Austin,
Texas. “The biggest sin is to overproduce.”

Operating leanly often requires moving
manufacturing processes from functional divisions
of work—where different departments stamp, mold,
drill, paint and so on—to work groups or cells
that together produce similar products. Rather
than having a part move from department to
department, which takes time, eats up floor space
and makes tracking difficult, all of the processes
needed to manufacture a product or line occur next
to each other in sequence.

Lantech Inc.
shows CPAs how this can work. Before moving to a
lean operation, manufacturing a packaging machine
could take up to 16 weeks, as parts moved through
nearly a dozen operations. The company kept large
parts inventories, and assemblies often sat idle
while they waited to move to the next step. Not
only did this waste space, it often caused extra
work as the machines would need touch-up paint,
having gotten nicked and dirty while traversing
the factory.

Capacity. The
volume of products or services a
business can produce with the resources
available to it.

Deferred labor.
The labor costs a company
incurs to produce a product it holds in
inventory. The costs are deferred until
the company sells the inventory. At that
time the costs move from the asset side
of the balance sheet to the expense side
of the income statement as cost of goods
sold.

Hurdle rate. The
rate of return a company requires before
it will invest in a product or
operation. It should generally equal the
company’s incremental cost of capital.

Inventory turnover.
The number of times a year
a company sells its inventory. This is
calculated as the ratio of annual sales
to the average value of inventory. An
equivalent measure is the fraction of a
year an average product remains in
inventory.

Just-in-time. An
approach to manufacturing whereby raw
materials and supplies are delivered to
a manufacturing operation just as they
are needed to meet demand. This
contrasts with batch-and-queue
manufacturing, in which a company holds
supplies and materials in inventory to
manufacture in large quantities, even if
demand for the products doesn’t meet
production levels.

Lead time. The
amount of time a supplier requires to
fill customer orders. Typically, the
shorter the time, the more efficiently
the supplier is operating.

Lean accounting.
Concepts designed to
better reflect the financial performance
of a company that has implemented lean
manufacturing processes. These may
include organizing costs by value
stream, changing inventory valuation
techniques and modifying financial
statements to include nonfinancial
information.

Lean manufacturing.
A strategy designed to
achieve the shortest possible production
cycle by eliminating waste. The goal is
to reduce inventory and produce only to
meet customer demand. Benefits include
lower costs, higher quality and shorter
lead times.

Scrap rate. The
percentage of products in a production
run that fail to meet specifications,
and thus can’t be sold at full price.
So, if a company has to “scrap” 5 of
every 150 products, its scrap rate is
3.3%.

Value stream.
The flow of activities
required to transform raw materials or
information into a product or service
for customer use.

Work cell. A
group of machinery, tools and employees
that produces a family of products.

Still, from
its founding in 1972 until the late 1980s,
Lantech’s production processes largely were
protected by patents and business grew. Then, its
patents began expiring and competition and price
pressure increased. “We were having a hard time
meeting customer delivery times. We would build
things partway and then put them on the shelf,
hoping we would have the right modules for actual
customer orders,” says Jean Cunningham who was,
until recently, the company’s CFO. “There was a
lot of cash and space tied up in inventory.”
(Cunningham now is the CFO of Marshfield Door
Systems in Marshfield, Wisconsin. She says she and
her colleagues at Marshfield are actively
following lean accounting principles.)

To
remain viable, the company went lean. Employees
created work cells for each of the four machine
models it produced. Instead of having parts moving
all over the factory, a cell performed all
activities needed to produce a machine in sequence
in one place. Workers were cross-trained to
perform various operations, and suppliers began
delivering parts on a just-in-time basis. “Within
a year, we were able to manufacture a product—from
cutting the steel to shipping it—in 15 hours,”
says Cunningham.

STANDARD COST ACCOUNTING DOESN’T FIT Those who have worked with lean
companies contend that many standard cost
accounting practices no longer make sense.
“Traditional accounting was designed to support
mass production,” says Mike Kuhn, CPA, partner
with Vrakas/Bluhm, S.C., in Brookfield, Wisconsin.
In addition, traditional cost accounting reports
were developed to present an accurate view of the
company to outsiders. Their purpose wasn’t to help
managers run their operations better. According to
Kuhn, “many of the accounting assumptions
contradict lean manufacturing.” As a result a
growing number of companies are implementing “lean
accounting” concepts to better capture the
performance of their operations.

Why
doesn’t standard cost accounting work? Under lean
manufacturing some nonfinancial measures including
lead times, scrap rates and on-time deliveries
show significant improvements, yet they aren’t
captured on GAAP financial statements. On the
other hand, net income usually declines—albeit
temporarily—when a company switches to lean
manufacturing. That’s because as the company works
through its existing inventory, deferred labor and
overhead move from the asset side of the balance
sheet to the expense section of the income
statement. Even though short-lived, the decline in
net income causes concern among executives,
investors and other financial statement readers.

Given these difficulties it’s not surprising
executives at Lantech and other lean companies
began looking for a better way to account for
performance. “As a company transforms itself from
traditional mass production to lean manufacturing,
the ways you count, control and measure are
different,” says Brian Maskell, CPA, president of
BMA Inc., a consulting firm in Cherry Hill, New
Jersey.

What are the differences? When
standard cost accounting was developed in the
early 1900s, most companies’ cost structures
consisted of 60% direct labor, 30% materials and
10% overhead, says Orest J. Fiume, a retired
vice-president of finance and coauthor with Jean
Cunningham of the book Real Numbers:
Management Accounting in a Lean Organization.
Companies typically allocated overhead costs
to products in the same proportion as direct
labor. “Overhead was so insignificant that even if
the allocation was incorrect, it wasn’t a big
deal,” he adds.

Today, the percentage of
direct labor in most manufacturing processes is
somewhere between 5% and 15%, says David Arnsdorf,
president of the Alaska Manufacturers’ Association
in Anchorage. So, is direct labor a good measure
for applying overhead? Arnsdorf and other lean
advocates, not surprisingly, say it usually is
not. Lean proponents also view inventory
differently. “Inventory is not an asset,” says
Maria Elena Stopher, manager of the national lean
initiative within the National Institute of
Standards and Technology (NIST) at the U.S.
Department of Commerce, Gaithersburg, Maryland.
“You have handling costs, it takes up floor space
and reduces cash flow.”

Treating inventory
as an asset in traditional financial statements
allows a company to match its cost against
revenue—as cost of goods sold—when it sells the
product. In lean operations, where the goal is to
produce only to meet demand, this strategy reduces
inventory to the point where it is negligible.

Equally important, the calculations used to
value inventory usually are erroneous in today’s
environment of rapid technological change.
“Historically, there’s been a bias to overvalue
inventory, because you presume it all will sell at
market price,” says Jim Womack, president of the
Lean Enterprise Institute in Brookline,
Massachusetts. As lean adherents point out,
products stocked in inventory often become
obsolete before the company sells them. As a
result they often sell for less than market value.

Lean accounting advocates point out that the
columns of variances from standard costs, standard
material usage, standard labor rates and the like
that show up in traditional financial statements
make them nearly impossible for most nonfinancial
people to understand. “We underestimate the
difficulty of interpreting financial information,”
says Caslavka of Landscape Structures.

IF NOT STANDARD COSTING, THEN WHAT? If standard cost accounting
doesn’t make sense in a lean operation, what does?
Adherents propose a new way of looking at the
numbers. For starters, rather than categorizing
costs by department, they organize them by value
stream. A value stream includes everything done to
create value for a customer that can reasonably be
associated with a product or product line, says
Maskell. Among the costs in a value stream would
be the expenses a company incurs to design,
engineer, sell, market and ship a product as well
as costs related to servicing the customer,
purchasing materials and collecting payments on
product sales.

Value streams cut across
functional departments, so that’s why one stream
can include sales and marketing, production,
design and cash collection costs. Ideally, each
employee is assigned to a single value stream,
rather than being split among several, as is
traditional with most employees. “We define the
value stream as best we can,” says Maskell. Then,
it’s a matter of gathering revenue and expenses
for the value stream to produce an income
statement. While corporate overhead costs are
accounted for, they’re shown below the line on
internal value stream reports, says Maskell. The
reason? Employees working in the value stream
can’t control them.

Lantech’s experience
shows how this scenario can play out. Previously,
accounting would look at the cost for each piece
or work order and then add an overhead allocation.
During her tenure as Lantech’s CFO, Cunningham
began reporting by value stream as the company
moved to lean manufacturing. “We tracked costs at
the product line level. I knew the revenue for the
line, the material for the line, supplies for the
line, scrap for the line,” says Cunningham. With
this information, managers easily can see whether
material use, scrap rates and labor costs for a
product line are moving up or down.

Inventory valuation also changes under lean
accounting. Because of the focus on producing only
to meet customer demand, inventories tend to be
much lower than in traditional manufacturing
operations. Thus, while the balance sheet includes
a line for inventory, valuing it may take just
minutes. Lantech, for instance, completes its
yearend inventory count in several hours, says
Cunningham.

In addition to making changes
to their financial statements, companies that
adopt lean processes often include nonfinancial
data in the statements. For instance, Caslavka of
Landscape Structures increased the level of detail
on sales discounts. “Previously, we viewed this as
one undissected pool of money. Now, we’re taking a
stronger look at how we spend the dollars and the
benefits we get.” For instance, the reports now
show the number of sales leads generated by
different promotional discounts. (For a comparison
of traditional and lean financial statements see
the exhibit .)

A PANACEA? Is it possible lean accounting
concepts are too good to be true? Even adherents
acknowledge some potential shortcomings. For
starters, there’s the challenge of accurately
pricing individual products and determining
profitability when CPAs analyze performance by
value stream, rather than by product.

One
example: How would management decide whether to
accept an order to make a particular product for
$10? First, accounting would look at the impact on
the overall value stream and determine how much
material or labor costs would increase, says
Maskell.

However, if the calculations
considered only the additional direct costs needed
to produce the order and excluded support
functions from outside the value stream, the
company’s profitability eventually would be
undermined because it failed to consider the
indirect costs. To prevent that, the company needs
to determine whether the new product will not only
make money but also beat a “hurdle” rate that
covers costs both within and outside the value
stream, he says. A hurdle rate refers to the
return the company requires before it will invest
in a product or operation. It should generally
equal the company’s incremental cost of capital.

If practiced too rigorously, a lean approach
could emphasize speed and quality almost to the
exclusion of cost concerns. For instance, machine
shops that make stamped metal parts frequently
have lead times of up to several days if they
haven’t applied any lean concepts. Simply by
reorganizing and better scheduling their work,
employees often can cut lead times to less than an
hour. From there, decreasing them to minutes or
seconds usually means investing in new machinery.
Arnsdorf says: “You can’t just apply lean blindly.
You have to look at costs. Faster isn’t always
better.”

Cheryl S. McWatters, PhD, CMA,
dean of the faculty of extension at the University
of Alberta, Canada, offers another view. “After
the fact you may want to know the norm and what
you spent,” she says. “Accounting information
regarding variances to budget can be a way to
control employees’ performance.” For instance, if
the company’s annual budget calls for a 10%
reduction in materials expenses but actual
expenses are the same as the previous year, the
manager responsible will have to account for the
discrepancy.

Finally, one of the most
significant concerns regarding lean accounting is
whether its principles conform to GAAP. Proponents
say not only do lean financial reports meet GAAP
requirements, but they actually more closely
follow the spirit of GAAP because they’re more
easily understood. “We don’t do anything that
isn’t in compliance with GAAP,” says Cunningham.
“Lean accounting is simply about doing the
reporting in a way that is simpler and easier to
follow.”

PRACTICAL TIPS TO
REMEMBER

Because
traditional accounting was
designed to support mass
production, many of its
assumptions contradict lean
manufacturing. As a result
CPAs may want to recommend
businesses with lean
operations implement
alternative accounting
concepts to better capture
their performance.

Lean adherents
suggest a new way of looking
at the numbers: Rather than
categorizing costs by
department, CPAs can recommend
companies organize them by
value stream, which includes
everything an entity does in
creating value for a customer
that it can reasonably
associate with a product or
product line.

CPAs should
encourage companies moving to
lean accounting to resist the
temptation to eliminate
standard reporting entirely.
Businesses should supplement
their traditional financial
statements with additional
information that captures the
improvements lean
manufacturing brings. Instead
of eliminating the standard
reporting system overnight,
companies should dismantle it
piece by piece as their
underlying operations change.

WHAT ACCOUNTANTS THINK The changeover to lean business
and accounting concepts hasn’t occurred without
some bumps. “The thought process was formed
outside accounting, so there’s always been a bit
of tension between it and traditional accounting,”
says Womack of the Lean Enterprise Institute.

In addition, many of lean’s tenets are contrary
to the natural tendencies of accountants, says
Daniel Szidon, a CPA and partner in Wipfli LLP in
Wausau, Wisconsin. “When CPAs work with numbers,
the goal is to fully allocate costs to precise and
stable cost centers,” he says. In contrast, lean
focuses on accounting for costs in a manner that’s
reasonably accurate. “The goal isn’t a perfect
allocation of costs. It’s an accurate, relative
measure of them.”

IMPLEMENTING LEAN ACCOUNTING As with any significant change in
operations, applying new accounting concepts
requires the committed support of top management.
“CEOs doing this can’t be just visionaries; they
have to be doers,” says Fiume.

When a
company moves to lean accounting, CPAs usually
will want to continue to supplement the entity’s
standard financial statements with additional
information that captures the related improvements
rather than eliminating the statements outright.
“You can’t turn off the standard reporting system
overnight,” says Fiume. “Instead, dismantle it
piece by piece as the underlying operations
change. In the meanwhile, prepare lean format
financial statements on a parallel basis” to
illustrate results both ways. For a sample of
hypothetical financial statements prepared
according to the traditional and lean methods, see
the exhibit .

Fortunately, most financial officers find the
cost information they need to prepare lean
financial statements already is available in their
company accounting systems. It’s just a matter of
reformatting the data, says Tawse of the Kaizen
Institute. For instance, rather than including
labor and overhead expenses in the cost of goods
sold, a lean financial statement will show
materials, labor and overhead as separate line
items. That way the company will recognize labor
and overhead expenses when it incurs them rather
that having them get wrapped into inventory on the
balance sheet.

GOOD FOR YOU? CPAs need to recognize the power
they have to help their employers become leaner
and more competitive in the marketplace. Because
of their skills, CPAs can make sure the
organization has accounting policies in place to
better reflect the positive impact lean typically
has. Otherwise, businesses that implement lean
strategies won’t be able to judge the bottom line
result and know for sure whether the change is
good for their business.

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